The hidden transfer pricing risks of your global ESG strategy

4 minute read  19.01.2023 Craig Silverwood, Sarah Barker, Phoebe Roberts, Beau Jellis

Whilst ESG initiatives become increasingly commonplace, the associated transfer pricing considerations can often lag behind. This can have significant implications on a company's global transfer pricing position and expose corporates to significant financial exposures and tax liabilities.

Key takeouts

  • Transitioning to more ESG-aligned businesses processes can create transfer pricing challenges, particularly in determining the cost and value of implementing sustainable practices
  • Robust documentation and clear transfer pricing policies are key to avoiding potential disputes with tax authorities, quantifying benefits to stakeholders and demonstrating the 'arm's length' value of sustainable investments.
  • To proactively manage any future transfer pricing review, corporates should document and evidence their transfer pricing position and work collaboratively with tax authorities to ensure they meet any evolving review requirements.

As stakeholder expectations evolve, environmental, social, and governance (ESG) considerations are becoming increasingly important for multinational corporations as they aim to shift their organisation to more sustainable business practices in their global value chain. ESG covers matters as diverse as ethical decision-making, diversity and inclusion, climate change, modern slavery and sustainable finance.

A growing number of policy frameworks, regulations and pieces of legislation are guiding businesses’ efforts in devising, implementing and reporting on more ESG-aware business practices. Organisations are also focused on sustainable value creation, with many accessing a growing pool of equity and debt finance looking to achieve both financial and social returns.

ESG considerations in transfer pricing

Over the last 20-30 years, many multinational organisations have adopted transfer pricing governance models to support their cross-border dealings. Transfer pricing is the method used to determine the price at which goods and services are exchanged between international related party entities, such as different subsidiaries of a corporation. These prices can have a direct impact on a company's tax liability, as they are used to determine the amount of profits that are attributed to different countries. Transfer pricing implications are often not contemplated by corporates in the broader mix of trade-offs or additional transition risks in designing their ESG strategy.

One of the key challenges related to transfer pricing and ESG is determining the cost and value of moving to more sustainable business processes. These changes may lead to increased product costs, increased supply chain costs and the creation/enhancement of intellectual property. A common example is when a company changes supplier locations to more closely align with their ESG targets. For example, an organisation may choose to shift from sourcing products from lower cost overseas suppliers, and instead source from suppliers in more established jurisdictions who can provide more transparency on their practices. In these circumstances it may be difficult to determine the 'arm's length' value of these investments for transfer pricing purposes, as the companies cost of goods increase without a corresponding increase in its short term operating income. This can create uncertainty and lead to disputes with tax authorities.

Furthermore, depending on the extent of change to the company's structure and/or supply chain following the implementation of such initiatives, this may be considered a 'business restructure' under the Australian Taxation Office's (ATO) wide meaning for the purpose Australian tax positions. Companies must be able to explain and defend business restructures, including the shifting of functions, assets and risks associated with ESG initiatives, within compliance reporting obligations.

How to manage ESG and transfer pricing obligations

To address these challenges, companies should prepare and implement robust transfer pricing policies and documentation to ensure that they are able to demonstrate that their revised transfer prices remain 'arm's-length'.

Transfer pricing documentation provides the opportunity to quantify the identified benefits from implementing these changes to business processes, that may not be truly reflected in a short term cost-benefit financial analysis. It can also identify and explain ancillary factors, such as when an organisation considers alternative options that are realistically available and the cost of not implementing ESG conducive changes. For example, there could be a potential increase to costs of borrowing and adverse consumer/investor sentiment.

There is also a growing trend within ATO transfer pricing reviews that companies must be able to not only document but also evidence their transfer pricing position. When implementing ESG practices, contemporaneous identification and collation of key decision makers and the key decision making documents (for example board presentations, underlying research/presentations and projected financial forecasts) will be a key way to proactively manage any future ATO transfer pricing review.

Finally, another way for companies to manage the impact of transfer pricing on their ESG initiatives is to adopt a collaborative approach with tax authorities. Companies can work with tax authorities to develop a shared understanding of the value of ESG business processes, which can help to avoid disputes and ensure that the company's transfer prices are consistent with the company's overall ESG strategy.

As companies continue to adopt ESG initiatives, they must also consider the potential impact these initiatives may have on their transfer pricing positions. By implementing robust transfer pricing policies, gathering and maintaining accurate data and documentation, and adopting a collaborative approach with tax authorities, companies can best manage the impact of transfer pricing on their ESG initiatives and avoid disputes with tax authorities.

MinterEllison is Australia's largest law firm, which houses market leading Climate and Sustainability Risk Governance, Transfer Pricing and Tax Controversy practice groups. Whether you are at the beginning of your climate and sustainability risk governance journey, or committed to best practice, MinterEllison’s multidisciplinary team can assist with the assessment, governance & management of climate-related risks, and the concurrent management of corresponding tax and transfer pricing risks.